YAIA

May 10th, 2012 at 5:26 pm

Q: In a recent post on the fiscal cliff you seemed to assume that Congress will “go off the cliff” and then retroactively fix everything in Jan or Feb. Assuming politics are about where they are right now—Obama wins and Congress remains divided—precisely what magic are you envisioning such that they all decide to work together on this, especially after a bitter election?

A: Well asked. Let’s see about well-answered.

No one knows the outcome, and as you suggest, it depends on who wins the election, but I must admit I’m counting on a few factors:

–Enough legislators will want to avoid recession. I’m not trying to be dramatic, but that’s the conclusion of the CBO, Bernanke, and others, broadly based on the idea that the economy will be growing at around 2% and the cliff amounts to a fiscal contraction of around 3.5%. Obviously, there are Kamikazes up there (though we don’t know the composition of the next Congress), but let’s hope they’re outnumbered.

–R’s will take credit for a massive tax cut. It’s not my preferred scenario, but I fear politics will push us off of the cliff. At that point, taxes go up by something like $280 billion…in one year. No one wants that—the President will have insisted that only the highend—about $80 billion—should have expired. So there’s an agreement to be had that cuts a ton of taxes and the cutters can brag on that.

Yes, this invokes some funky baseline issues—the big tax cuts will be relative to what we call current law which assumes full sunset. Under the current policy baseline, the above would look like something of a charade.

Anyway, that’s the magic.

“Is that it? That’s all you got?!,” you ask. “Yep,” I answer.

Q: What’s going on with financial reform? How much of it is in place? How effective do you think it will be? Seems like “too-big-to-fail” banks are bigger than ever.

A: Hey, I just did a radio show on that—the excellent Warren Olney show in LA—here’s the link. The setup was, “are some of our banks still too-big-to-fail?”

The answer, as I see it, is probably yes, but that’s not really the right question.

First, as I stressed in the show, the issue is less size than interconnectedness. Lehman was about fifth or sixth in terms of size but its debts were held by many other institutions across the globe.

Second, Dodd-Frank, aka financial reform, is in the midst of being implemented. That made up a large part of the discussion on the show, so take a listen, but to break it down, the banking lobbyist basically argued that “everything’s going fine” and the consumer advocate argued, “no, it’s not.”

From what I’ve seen, the CFPB (consumer protection bureau) is actually up and running and providing useful consumer services, but the director is only a recess appointee who’s likely toast at the end of the next session of Congress (I hope I’m wrong—this guy Cordray is excellent).

On the show I discuss two key components of the bill left to implemented: capital reserves and the Volcker rule. Both are critical in the following sense. It’s actually hard to imagine that if there’s another massive debt bubble there won’t be any bailouts. So we should try to minimize the likelihood of such large debt bubbles. One way to do that is by insisting the banks not become over-leveraged which implies keeping a lot more capital in the vaults than was the case during the bubble.

As you can hear from the industry guy, they don’t like that…they want to use their capital to leverage up and make multiples of it as returns. As so they should. But Dodd-Frank insists they keep more of a cushion on hand and that’s a key regulatory fight right now.

As for the Volcker rule, there’s the same basic tension between regulators crafting the rule and banks who want to trade more of their books like they used to in the bad old days. Here’s my take.

Q: Re my post on a model of leverage as a function of higher inequality: Why doesn’t the increased risk of lending based on increased debt/income ratio show up as a higher cost of borrowing? Doesn’t the risk seeking behavior of the lenders have to be increasing as they become more wealthy to keep the price from increasing? If they were risk neutral, the cost of borrowing should increase as the risk does, shouldn’t it?”

A: Not necessarily, and if you read your Hy Minsky, necessarily not. You’re right that the demand for loanable funds would lead to higher interest rates, all else equal, but if enough money floats to the top, the supply of funds will increase to meet the greater demand and the price of borrowing will remain the same.

But there’s also the debt bubble, instability problem. Minsky believed that as recoveries mature, risk tends to become underpriced in financial markets. I’m trying to think of examples of that…hmmm…

Q: (re same post) Do you think a similar model could be developed where certain countries play the role of the big savers, and certain other (stagnating?) countries play the role as the big borrowers?

A: Absolutely. The joke during 2000s was that re China, they sent us toxic toys and we sent them toxic assets…ha-ha, right?

Q: Re my post on how absent all those state and local layoffs, the unemployment rate could be a point lower: How much additional stimulus would have been required from the Federal government to the States in order to have kept those layoffs from occurring? How much GDP has been lost as a result of the decrease in employment? Are these not the benefits and costs of “austerity”?

A: Rough estimates, a point of unemployment equals around two points of GDP, or about $300 billion. That’s about what we had for fiscal relief in the Recovery Act, and it worked well—probably among the most efficient components of the act. With a multiplier of 1.5—that’s my guess for state fiscal relief right now, we could get there with $200 billion (200*1.5=300).

But the costs of stimulus are actually a lot lower than that right now, because the Federal gov’t can borrow at very cheap rates, and in generating more growth, help to spin off more future revenue to pay down this debt later.

How cheap? DeLong and Summers argue that under current conditions, “fiscal policies may reduce long-run debt-financing burdens.” That’s a little Laffer-curvy for me, but if you factor in the long run losses from all the slack we end up with by sitting on our hands when real interest rates are negative, they’re surely more right than wrong.

Q: From my post re Apple’s tax-avoidance machinations: Would trading the corporate income tax for a VAT make it easier, more transparent, harder to avoid, and harder to demonize?

A: Definitely harder to avoid, but a number of questions arise.

First, is it realistic to believe that we could adopt a value-added tax? Not to put too fine a point on it, but “no.” At least I don’t see how we get to there from here in the medium term—and I say this as a veteran of literally decades of tax debates that ended with: “…and that’s why we need a VAT!”

Second, an important question here is the incidence of the VAT—who pays the national sales tax, which is what the VAT reduces to, versus who pays the corporate tax. The sales tax tends to fall on the consumer, i.e., the incidence of the VAT keeps getting pushed along the supply chain until the end of the line.

But the incidence of the corporate tax is less well understood. I think it largely falls on capital, though my evidence is in no small part drawn from the observation that since capitalists complain about it, its incidence must fall on capital. If I’m right, then this idea is regressive. In fact, I’m sure it’s regressive, but perhaps with the revenue you’d raise from a VAT you could offset that regressivity (though, admittedly, that sounds complicated, and you’re trying to make things simpler!).

Q: Re my post of the limits of the Fed: Countries like Sweden, Israel and Australia that have pushed their own currencies’ inflation to about 4% have done the best in this recession. The Fed could just announce that they will increase money supply until they get 4% inflation, and that will set market expectations. Should the promise be held as credible, it would move the market almost immediately. The same thing happened in Switzerland, they said they would print money until the current devalued to X level, and almost overnight it went to that level. Then, their exports became more competitive.

A: Right, and not only competitive exports through currency devaluation but also faster debt deleveraging (as inflation erodes the nominal value of debt burdens). You’d have to balance this against deeper real earnings losses, however. Real wages are already down around 1% yr/yr, and this would lead to something more like 2% losses.

But it is an idea you’ll hear from a lot of folks these days, and by no means radicals—Ken Rogoff, for example, espouses this route to recovery.

But remember how the Fed works at a time like this. They’re out of room on the interest rate so they buy debt. Putting aside their stated desire not to do a lot more debt purchases right now, perhaps if they committed to numerous more rounds of QE, such liquidity flooding would raise prices as you suggest. But as I noted in the post, I suspect they’d end up “pushing on a string” and absent greater demand, nothing much would change. True, more exports and more deleveraging translates into greater demand, so this is certainly a legit idea but it’s not as surefire as some folks seem to think.

Q: How about tying the Bush tax cuts to the unemployment rate? They would not sunset until unemployment falls to some very low level.

A: I think it’s fine to sunset the highend cuts ASAP. Otherwise, they risk becoming a pretty much permanent fixture of our tax system. But re the rest of the cuts, I very much agree re tying the sunset to the unemployment rate and have suggested as much in various posts. BTW, to some extent, in a progressive tax system, you get this effect anyway. As the economy improves and incomes begin to grow again, people move into higher tax brackets.

3 comments in reply to "YAIA"

-“If they were risk neutral, the cost of borrowing should increase as the risk does, shouldn’t it?”

Thanks for the reply Jared! I get that the supply of loanable funds drives the price down for debt generally; what I’m questioning relates more to the second part of your response: “Minsky believed that as recoveries mature, risk tends to become underpriced in financial markets.” This is the increase in “risk seeking” behavior I was referring to. If the price of the riskier debt rose as the risk (debt/income) did (relative to “safe” debt – in a CAPM sort of way for lack of better descriptor), the increased loanable funds would flow more to the safest debt and drive those prices down further (further increasing the spread between safe & risky debt); but that doesn’t seem to be what tends to happen. So is this just a “market failure” or is it likely to be a function of concentration of wealth in the hands investors who are now more likely to pursue greater risk with this wealth than would be the case if the wealth were more evenly distributed (and included a greater proportion of risk neutral and risk averse investors)?

I think what happens is that safe and risky debt gets conflated and so the pricing patterns you suggest don’t materialize. Securitization, sloppy underwriting, and mistakes by rating agencies didn’t help.

I agree, good counterfeiting will circumvent any pricing mechanism and won’t be reflected in prices until its discovered. But didn’t this same thing (underpricing of risk) happen in the lead up to the Great Depression?

I was hoping the Reinhart/Rogoff book would have addressed this but they never seemed to address why these “mis-pricings” would be so pervasive over such a long period of time. I doubt its random; seems something systematic underlies it.

Thanks again for all of your hard work shining the spotlight on these issues!